The
China Syndrome (1979) was a movie on the threat of a nuclear
power plant’s core meltdown. The phrase was said to refer to the
core of the plant’s falling all the way to China. The producers
were blessed by the March 28 Three Mile Island nuclear power plant
emergency, which for a time looked extremely serious. The movie
was released on March 16.

There is
another China syndrome, also associated with a meltdown. This
would be triggered by the central bank of China’s doing nothing.

To understand
how this could happen, it is useful to see how a similar scenario
took place in 2008.

WHEN
BEARS GROW STEARN

The bankruptcy
of Bear Stearns in March 2008 was a prelude to a wider meltdown.
Wikipedia summarizes what happened.

In March 2008, the Federal Reserve Bank of New York provided an
emergency loan to try to avert a sudden collapse of the company.
The company could not be saved and was sold to JP Morgan Chase
for $10 per share, a price far below its pre-crisis 52-week high
of $133.20 per share, but not as low as the $2 per share originally
agreed upon by Bear Stearns and JP Morgan Chase. The collapse
of the company was a prelude to the risk management meltdown of
the Wall Street investment bank industry in September 2008, and
the subsequent global financial crisis and recession. In January
2010, JPMorgan ceased using the Bear Stearns name.

The parent
company the previous June had bailed out two of its hedge funds.
It placed $3.2 billion of its own capital on the line for the
funds. The funds were leveraged with CDO’s: collateralized debt
obligations.

Bear Stearns
had originally put only $35 million into the fund. The senior
managers thought it would tarnish the firm’s reputation if it
let a hedge fund with its name on it go under. So, they did what
was stupid in retrospect. They mortgaged the family jewels.

Next, Richard
Marin, the man who was in charge of the two busted hedge funds,
was replaced on June 29 by Jeffrey B. Lane, a former Vice Chairman
of a rival investment bank, Lehman Brothers. So, in order to bail
out a pair of busted, over-leveraged hedge funds, Bear Stearns
called in a Lehman Brothers executive. That turned out to be a
foretaste of things to come.

In July,
the firm announced a total bust. There was no money remaining
in either fund. Leverage giveth, and leverage taketh away. There
was the predictable class-action lawsuit filed on August 1. Then
came another from Barclay’s Bank. The company’s reputation began
to sag.

Things held
together until the second week of March 2008. At that point, a
bank run began.

In the good
old days before the Federal Deposit Insurance Corporation was
created by the government, a bank run began when depositors lined
up to get their money out. The bank then had to sell assets to
get money. In the Great Depression, this took down 9,000 banks,
all small. The Federal Reserve protected the big banks. The FDIC
stopped these runs by reducing the depositors’ fears.

In the modern
world, a bank run does not begin in front of a bank. It begins
when the bank’s big creditors, hedge funds and pension funds,
decide not to roll over their short-term credits to the bank.

There are
few warnings. Credit lines are short-term. The bank’s president
gets a call telling him that the creditor intends to take his
money and not roll over the loans to the bank.

These funds
are not protected by the FDIC. So, the creditors get jumpy when
rumors of insolvency spread. That was what happened to Bear Stearns
in the second week of March 2008.

Then came
the bailout from the Federal Reserve Bank of New York, a private
company. Wiki reports:

On March 14, 2008, the Federal Reserve Bank of New York agreed
to provide a $25 billion loan to Bear Stearns collateralized by
free and clear assets from Bear Stearns in order to provide Bear
Stearns the liquidity for up to 28 days that the market was refusing
to provide.

Then it
reversed itself. It decided to set up a sweetheart deal for
J. P. Morgan. It told BS that there would be no loan. Instead,
it made a $30 billion loan to Morgan, but did not require Morgan
to put up any of its own collateral. The NYFED accepted Bear
Stearns’ assets. This collateral was basically worth nothing
in the short-term.

Two days
later, on March 16, 2008, Bear Stearns signed a merger agreement
with JP Morgan Chase in a stock swap worth $2 a share or less
than 7 percent of Bear Stearns’ market value just two days before.
This sale price represented a staggering loss as its stock had
traded at $172 a share as late as January 2007, and $93 a share
as late as February 2008. In addition, the Federal Reserve agreed
to issue a non-recourse loan of $29 billion to JP Morgan Chase,
thereby assuming the risk of Bear Stearns’s less liquid assets
(see Maiden Lane LLC). This non-recourse loan means that the
loan is collateralized by mortgage debt and that the government
can not seize J.P. Morgan Chase’s assets if the mortgage debt
collateral becomes insufficient to repay the loan. Chairman
of the Fed, Ben Bernanke, defended the bailout by stating that
a Bear Stearns’ bankruptcy would have affected the real economy
and could have caused a “chaotic unwinding” of investments across
the US markets.

That arrangement
created a firestorm of protests from Bear Stearns’ stock holders.
They filed a class action lawsuit. So, Morgan raised the ante
to $10 a share. That got them the prize – the FED-bankrolled
prize.

Then Wiki
gives us this choice bit of information.

On March 20, Securities and Exchange Commission Chairman Christopher
Cox said the collapse of Bear Stearns was due to a lack of confidence,
not a lack of capital. Cox noted that Bear Stearns’s problems
escalated when rumors spread about its liquidity crisis which
in turn eroded investor confidence in the firm. “Notwithstanding
that Bear Stearns continued to have high quality collateral to
provide as security for borrowings, market counterparties became
less willing to enter into collateralized funding arrangements
with Bear Stearns,” said Cox. Bear Stearns’ liquidity pool started
at $18.1 billion on March 10 and then plummeted to $2 billion
on March 13. Ultimately market rumors about Bear Stearns’ difficulties
became self-fulfilling, Cox said.

This was
a CMA announcement. Translated, it meant that the SEC was not
derelict in its duties by failing to see this coming. Bear Stearns
was technically insolvent, but not really. It became insolvent
only because of rumors.

Notice what
this really means. A company with $18 billion in liquidity on
March 10 lost $16 billion of this liquidity in three days.

Welcome
to bank runs of the twenty-first century.

LEHMAN
BROTHERS: BEAR STEARNS ON STEROIDS

Six months
later, a similar scenario played out with Lehman Brothers, a $600
billion investment bank. Does this sound familiar?

Lehman borrowed significant amounts to fund its investing in the
years leading to its bankruptcy in 2008, a process known as leveraging
or gearing. A significant portion of this investing was in housing-related
assets, making it vulnerable to a downturn in that market. One
measure of this risk-taking was its leverage ratio, a measure
of the ratio of assets to owners equity, which increased from
approximately 24:1 in 2003 to 31:1 by 2007. While generating tremendous
profits during the boom, this vulnerable position meant that just
a 3 – 4% decline in the value of its assets would entirely
eliminate its book value or equity. Investment banks such as Lehman
were not subject to the same regulations applied to depository
banks to restrict their risk-taking. In August 2007, Lehman closed
its subprime lender, BNC Mortgage, eliminating 1,200 positions
in 23 locations, and took a $25-million after-tax charge and a
$27-million reduction in goodwill. The firm said that poor market
conditions in the mortgage space “necessitated a substantial reduction
in its resources and capacity in the subprime space”.

Bear Stearns’
two leveraged funds went down in June, 2007. The class action
suit began on August 1. That same month saw the loss of the Lehman
subprime fund. Then came the decline. “In the first half of 2008
alone, Lehman stock lost 73% of its value as the credit market
continued to tighten. In August 2008, Lehman reported that it
intended to release 6% of its work force, 1,500 people, just ahead
of its third-quarter-reporting deadline in September.”

It took
a year for the rumors to spread. The stock price continued down.
But Lehman was too big to fail. A lot of investors hung on. Then
came Armageddon. The company had been heavily invested in subprime
mortgages. Henry Paulson on September 7 unilaterally announced
the nationalization of Freddie Mac and Fannie Mae. He called the
new government-ownwd system a “conservatorship.”

On September
9, Lehman shares fell another 45%. On September 13, Timothy Geithner,
who was then president of the Federal Reserve Bank of New York,
called a meeting on the future of Lehman, which included the possibility
of an emergency liquidation of its assets. The weekend meeting
began. Note: the head of a private owned firm called the meeting.
The Secretary of the Treasury showed up.

The weekend
deal between Treasury Secretary Henry Paulson persuaded the Bank
of America to buy Merrill Lynch for $50 billion. (That was later
cut to $20 billion.) But there was no bailout of Lehman.

Then
came the next deal.

Lehman Brothers filed for Chapter 11 bankruptcy protection on
September 15, 2008. According to Bloomberg, reports filed with
the U.S. Bankruptcy Court, Southern District of New York (Manhattan)
on September 16 indicated that JPMorgan Chase Co. provided Lehman
Brothers with a total of $138 billion in “Federal Reserve-backed
advances.” The cash-advances by JPMorgan Chase were repaid by
the Federal Reserve Bank of New York for $87 billion on September
15 and $51 billion on September 16.

So, the
big winner was J. P. Morgan, just as it had been the winner in
the Bear Stearns deal six months before.

The lesson:
bad news can hit a year or more before the collapse. It is like
a fuse being lighted. Confidence erodes, but it does not collapse.
Then, overnight, it does.

CHINA’S
LEVERAGE

The People’s
Bank of China owns almost $1.2 trillion in U. S. Treasury debt.
It is the largest holder. Close behind is Japan. You
can see which nation owns how much of U.S. Treasury debt in the
Treasury Department’s monthly TIC report.

Take a look
at the report. China held a maximum of a little over $1.3 trillion
in July 2012. Then
it began to reduce its holdings by about $140 billion by January.
The official policy of the bank is for greater diversification.
This is a code phrase for “selling Treasury debt.” But there has
been no timetable. There have been no official targets.

We know
this: by mid-2011, China
had gotten rid of almost all of its T-bills, meaning 90-day
IOUs. It was holding U. S. bonds. So, when it ceases to buy bonds
that come to maturity, its holdings fall. It does not have to
sell T-bonds. It simply lets them mature. The U.S. Treasury must
then credit China’s account with this money. The central bank
takes the money and runs.

This is
what happened to Bear Stearns. The creditors refused to roll over
their loans. These were short-term loans. But China’s loans to
the Treasury are longer-term loans.

The quiet
way to get out of the dollar is to do nothing. Just take the dollars
from the Treasury and invest them elsewhere in U.S. markets, or
sell them for other currencies.

It is not
clear that China has begun a bank run on the Treasury. But word
is beginning to get out. If the bank’s present policy continues
– a refusal to roll over maturing debt – the Treasury
Department will have to find new buyers.

China is
Keynesian. It uses monetary inflation to fund spending, including
the purchase of Treasury IOUs. It can spend this on domestic purchases.
It will take time to shift from its export-driven policy to a
domestic-driven economy. But, either way, it is demand-side economics:
Keynesianism.

China ran
a slight trade deficit in February. Oil imports were the main
reason. Experts in China’s trade say that this was temporary.
But
they do admit that the surplus this year will be lower. I
think the trend is toward a smaller surplus. China needs energy
to sustain its growth. It will have to pay for this.

For as long
as the dollar remains the primary currency of oil-exporting nations,
oil-importing nations will buy dollars. There is an incentive
to get dollars by selling to the USA. But the risk of continuing
to hold T-debt is growing.

There will
come a day, just as it came to Bear Stearns, when the refusal
of creditors to roll over the debt will increase. Then, without
warning, the rollovers will cease. The creditors will decide to
keep their dollars and forgo the rollover. On that day, the Treasury
will have to go to the FED and demand that the FED buy its debt.
That’s the supplement benefit of a central bank from the politician’s
perspective. This will create a moment of truth for American politicians.

CONCLUSION

The first
indications of a bank run by China have begun. There is no panic
yet. The system is bumping along. But if China does not reverse
itself soon, it will become clear that the U.S. Treasury is over-leveraged.
It has more debt than its income can sustain.

That is
when the Secretary of the Treasury will call the chairman of the
Federal Reserve System and ask for a bailout. He will get it,
but its effects will not last. There will be another call. As
surely as Bear Stearns was followed by Lehman Brothers, so will
there be more calls from the Treasury Secretary to the chairman
of the FED.

There
will come a day when the FED’s chairman treats the Secretary of
the Treasury the way that Paulson treated Lehman’s Dick Fuld.
Let us not forget what
happened next.